Cloud Computing: The Next Bubble?

Cloud computing in simple terms is internet based computing. Software as a Service (SaaS) is software that is deployed and accessed over the internet. Saas is also called “software on demand”. Both these technologies are the rage nowadays. Companies that directly or indirectly operate in this space are considered the next Microsoft (MSFT) and Google (GOOG). Both Microsoft and Google are also creating products and services that will be delivered as a service and over the ‘cloud’ if you will. You may have heard about Google Docs which is similar to Microsoft Office; instead you access it via your browser from anywhere in the world. As a regular user of Google Docs and being in the IT profession, I can certainly appreciate the value of such services. Let us take a look at four companies whose business models are related in some way to cloud computing.

Two big and popular names that sport large market caps:

First up we have Salesforce.com. “salesforce.com, inc. provides customer and collaboration relationship management (CRM) services to businesses and industries worldwide.” Salesforce.com was founded in 1999.

Then we have VMware. “VMware, Inc. provides virtualization infrastructure software solutions and related support and services primarily in the United States.” VMware is a subsidiary of EMC corporation (EMC).

Data sources: Yahoo Finance, Old School Value spreadsheets (the 5 year median numbers are computed by measuring the metric across different spans of the 5 year period and then taking the median of all those numbers)

I am left speechless looking at these valuations. Yes, I notice that all the above companies have demonstrated excellent top line growth as shown by the 5 year median sales growth number. All these companies with the exception of Taleo have shown good to excellent earnings growth and cash flow growth.

However, when I look what investors are paying for these ‘growth’ companies, it makes me think of the valuations in the crazy days of dot.coms in 1999-2000. One thing going for these companies compared to most of the companies that dot.bombed is that they are profitable and have been around for several years. They have grown sales and earnings.

PEG

I can understand that ‘growth’ investors look at their sales growth and are excited. However, looking at the PEG ratio (which is a ratio of P/E to the expected growth rate), you will see that investors are paying way too much for growth. Peter Lynch who made the PEG ratio popular would look at companies where the PEG ratio was less than 1. He reasoned that means that even though the P/E seemed high, if he could get growth for less than the earnings multiple, it was a decent investment.

EV / Sales

I presented the EV / Sales number to show the high multiples being paid on the sales of these companies. For comparison, the EV / Sales for Apple (AAPL) is 4 and for Google is 4.7

P/E

And finally, the P/E ratios are just mind boggling. I know some people will say that these numbers are based on depressed sales and earnings and that when times are better, these numbers will look better and come down really fast. I do not doubt that the P/E ratios will come down. How much the P/E ratios will come down due to earnings (E) growing faster than the stock price (P) or due to P/E compression remains to be seen.

My Conclusion

All of the above companies could very well have excellent products and services. They could turn out to be great businesses as well. However, I am not sure if these companies are good investments at these levels. There will always be plenty of investors seeking out ‘growth’ by chasing the next hot stock / sector of the day / week / month without paying attention to the valuation or the fundamentals. However, investors who stay disciplined and invest in good businesses trading below their worth and with a margin of safety should continue to be rewarded.

Disclosure: I have long positions in GOOG and MSFT. I do not have any positions in CRM, VMW, CNQR, TLEO and AAPL.

Adib Motiwala is an MBA candidate with a concentration in Finance at the University of Texas at Dallas. He is employed as a software developer and has 10 years of experience in the IT industry. He manages his own portfolio and has a value investing bent. He writes on his blog at http://adibmotiwala.blogspot.com